A Strong Wind Lifts Red Robin

; recent price, $45) is likely to continue at least through the end of 2005. Our favorable view is most firmly tied to the strong continuing demand we expect from Red Robin's customers. We believe this demand provides the company with favorable pricing power and supports even higher operating profit margins. We look for returns on investment to rise with operating margins, laying the foundation for much wider geographic penetration and growth.

After nearly doubling in value during the second half of 2004, the stock has given back a portion of those gains to start the current year. We think much of the recent sell-off derives from the chain's fourth-quarter earnings results, which were modestly reduced in mid-January to reflect new accounting treatment for equipment. In our view, the recent pullback presents investors with an attractive opportunity to own the shares. By the end of the year, we expect the market to award the shares with a higher earnings multiple. The stock carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy.

MORE RESTAURANTS EXPECTED. Red Robin opened its first restaurant in 1969 in Seattle. In 1979, the first franchised unit opened in nearby Yakima, Wash. Since then, the company's restaurants have spread throughout the U.S., with the Southeast remaining the only region where its expansion has yet to penetrate as of early 2005.

In addition to gourmet burgers, which account for less than 50% of total food sales, the restaurants serve an array of other food items, including salads, soups, fajitas, pastas, and desserts designed to appeal to a broad range of guests. In 2004, the average check per person, including beverages, added up to almost $10.

When Red Robin went public in July, 2002, it had more franchised units than owned ones. Since then, its growth has favored corporate restaurants over franchisees. At the end of 2004, it owned and operated 137 domestic eateries, with an additional 118 operating as franchises in the U.S. and in two Canadian provinces. With relatively few exceptions, nearly all of its corporate restaurants operate via long-term leases. In February, 2005, management reiterated its view that demand in North America would support 800 additional restaurants systemwide.

HIGHER MENU PRICES. We think that Red Robin will earn $1.92 a share in 2005, compared with the $1.46 it posted in 2004. Strong consumer demand rates as the most important assumption supporting the 30% earnings growth rate we anticipate in the year ahead. We expect same-restaurant sales growth to approach 5% and the first quarter of 2005 to mark the company's 33rd straight interim period of comparable-store sales increases at corporate units. We anticipate that overall same-store comparisons for the full year will benefit about evenly from higher prices and increased guest counts.

We note that a menu price increase implemented this past June should add a degree of difficulty to second-half 2005 comparable-sales comparisons. However, we believe that management is highly sensitive to the trade-off between prices and traffic. And all else being equal, we would like to see an even balance between these two measures. If necessary, we believe strong demand would facilitate an additional menu price hike within the year.

We look for the number of eateries systemwide to increase from 14% to 18% this year, with growth in corporate sites toward the high end of this range and franchises near the low end. We believe that corporate restaurant openings will focus primarily on Midwest and Mid-Atlantic states and that franchised unit expansion should emphasize Texas, Michigan, and certain northeastern states, including New Jersey and New York.

FRANCHISES LESS PROFITABLE. In the past, sales increases, especially in terms of same-store sales, have coincided with improved margins. We expect this relationship to continue in the year ahead as a result of the operating leverage we see. For 2005, we think operating margins at the restaurant level -- excluding expenses such as overhead, depreciation, and preopening costs -- will rise by almost 100 basis points, due mostly to this expected sales leverage, along with modest relief in food costs.

Although we believe Red Robin has assembled a strong base of franchisees -- attracted by significant returns on investment along with relatively high margins -- we forecast that long-term unit expansion, like the growth we forecast in 2005, will depend more on company-owned locations than on franchised sites. Not taking into account the quality-control issues that occasionally arise among franchisees, we attribute this prediction most heavily to the fact that company restaurants contribute far more to Red Robin's profitability than franchised units.

Notwithstanding the company's modest fourth-quarter shortfall, Red Robin has generally outperformed earnings expectations. The result, in our view, was that in each of its first two full years as a public company, the stock's performance trended higher as these favorable profit surprises were realized. We think this pattern will continue in 2005, and our EPS forecast of $1.92 for the year rests comfortably above the high end of management's recent guidance of $1.75 to $1.77.

ATTRACTIVELY VALUED. We deem the overall quality of Red Robin's earnings above average. The entire 7-cent difference between our 2005 EPS forecast (on a generally accepted accounting principles, or GAAP, basis) and S&P Core Earnings estimate of $1.85 is composed of projected stock-option issuances expense, which the company currently excludes from its earnings presentation.

We think publicly traded restaurants have historically paid a relatively large portion of compensation in the form of equity and that options have been the preferred method of payment. Thus, we believe that, compared to other small and rapidly growing restaurant companies, Red Robin's relatively favorable earnings quality is even more noteworthy.

We consider Red Robin attractively valued, based on both price-to-earnings and "sum-of-the-parts" valuation methodologies. Our 12-month target price of $57 corresponds to a multiple of about 30 times our 2005 EPS forecast. Red Robin has typically traded at about this valuation level during its short history as a public company. We arrive at this same $57 target price through a sum-of-the-parts approach, which starts with forecasting 2005 restaurant-level operating income of almost $120 million. To this profit figure, we then apply an approximate multiple of 9 times and reduce this sum by our estimate of yearend net debt.

Risks to our recommendation and target price, in our view, include a potential decline in same-store sales at company-owned units. We think healthy sales growth drives margins and returns on investment as well as demand among prospective franchisees. At the same time, we also see some risk of undue focus on comparable-store sales increases, at the expense of overall profitability. Analyst Mack follows shares of restaurant companies for Standard & Poor's Equity Research Services